From late 1997 through the third quarter of 2001, continuing
fiscal surpluses by the federal government
caused the outstanding stock of Treasury debt to decrease
substantially. While the onset of the current recession,
along with the recent tax cuts, has slowed or
even reversed this trend, many analysts believe that
the declines in Treasury debt will resume over the next
decade once the economy starts to strengthen. This
could present an operational problem for the Federal
Reserve. The Fed currently injects liquidity into the
economy by expanding bank reserves via open market
operations. That is, the Federal Reserve expands
liquidity by purchasing securities on the open market
and withdraws liquidity through open market sales of
securities. Currently, all permanent transactions by the
Federal Reserve open market desk use Treasury securities,
and Treasury securities remain the primary medium
for temporary transactions. As demand for currency
and dollar-denominated bank reserves grows in the
years to come, the Federal Reserve will have to acquire
ever-increasing amounts of Treasuries via open market
purchases. But if the total stock of such securities shrinks
over the next decade or two, the Fed may find it increasingly
difficult to conduct the needed transactions.